Page 264 - FM Integrated WorkBook STUDENT 2018-19

Chapter 14

2.2 The shape of the yield curve

Three theories:

 Liquidity preference theory

Investors have a preference for more liquid (shorter maturity) investments and
will need to be compensated with a higher return if they are deprived of cash for
a longer period.

 Expectations theory

The normal upward sloping curve reflects the expectation that inflation levels,
and therefore interest rates, will increase in future.

 Market segmentation theory

This suggests that there are different players in the short-term and long-term
ends of the market. The yield curve is therefore shaped according to the supply
and demand of securities within each maturity length and the two ends of the
curve may have different shapes.

2.3 Use of the yield curve

Financial managers should inspect the shape of the curve when deciding on the term
of borrowings or deposits.

e.g. a normal upward sloping yield curve suggests that interest rates may rise in the
future:

 avoid borrowing on long-term variable rates

 choose to borrow on short-term variable or long term fixed rates instead.

254